How do companies make a profit

Company and production

Birgit Weber

To person

Dr. phil., born in 1959, is currently the professor for didactics of the social sciences at Bielefeld University. From 1989 to 2006 she worked in the field of economics and didactics of economics at the University of Siegen, where she headed a project to promote entrepreneurship in teacher training (2000 - 2002) as managing director of the Center for Teacher Training. As deputy chairwoman of the German Society for Economic Education, she helped drive the development of educational standards for economic education. In addition to fundamental questions of didactics in economics and social sciences, her specialist areas of focus are above all the culture of entrepreneurship, environmental economics and questions of the relationship between the state and the economy.

Contact: [email protected]; [email protected]

Profit is the goal of entrepreneurial activity. It arises when the sales achieved on the market are higher than the production costs. Company accounting and double-entry bookkeeping provide information on this.

After company founder Michael Bloomberg was elected Mayor of New York in 2001, the billionaire retired from management. (& copy AP)

introduction

Decisions about the introduction of new products, about changes to production processes, the hiring or firing of employees are primarily geared towards making a profit in a market-based company. This orientation is also known as the commercial principle. However, it only reflects the goal of entrepreneurial activity in abbreviated form. While measures to reduce costs and increase sales are aimed directly at increasing profits, strategies for expanding market share up to market leadership can increase profits in the long term, but cause losses in the short term. Undoubtedly, companies without profits cannot survive in the long run. However, the profit making itself is influenced by many framework conditions:
  • If the customers' needs for reasonable prices and good quality are not taken into account, this will have an impact on sales.
  • If employees are demotivated by poor working conditions or low wages, this can have an impact on the quality of the products.
  • If cost reduction is the top priority, poor quality can have a lasting negative impact on a company's reputation and the prestige of its products.
  • If the goal of generating profits is neglected, no investments or innovations to maintain or expand the portfolio are initially possible; in the long term, the company's existence is at stake.
  • If the increase in the company's value, expressed in the market value of the shares, and the payment of dividends are neglected, investors lose interest in the company and withdraw their shares or are reluctant to lend.


Profitability and increased productivity

A basic prerequisite for economic activity is a sensible use of the available funds, regardless of whether profits are aimed at, only costs are covered or even subsidies are claimed. If companies do not manage their scarce resources economically, they waste resources and incur higher costs than necessary. The consequences are easy to foresee: If the higher costs cannot be passed on to consumers through prices due to competition, profits will initially be lower, and finally there will be no expansion investments or wage increases.

Economy: economic principle
In this respect, the economic principle is the basic business norm for entrepreneurial activity and is at the same time the traditional basis of economic theory. According to this, either the given resources should be used in such a way that they bring the greatest possible return (maximum principle) or a desired return is achieved with the least possible use (minimum principle). Contrary to popular belief, doing business economically does not mean achieving as much as possible with as little as possible. Turned to the extreme, this would mean achieving everything with nothing - i.e. realizing maximum profit without investing funds. Such situations are not entirely impossible, but they are more the result of a rare coincidence, a happy exception. In contrast, economic action means first of all the planned deployment and sensible use of resources to achieve a certain result. Nevertheless, economic activity does not necessarily result in profits, because whether economic activity is rewarded by success or punished by failure ultimately depends on the market, with the intensity of competition influencing the scope for profit realization.

While "Made in Germany" was internationally regarded as a seal of quality that justified the higher price of the products until the 1980s, the industrialized countries of the Far East that caught up in the process demonstrated that good quality could also be offered at low prices. With the comprehensive corporate philosophy of lean production, the economic principle gained even greater importance. This "lean production" did not just refer to production, but also to product development, design, procurement and sales. According to this, the customer's wishes should be met with high quality with the least possible use of resources in terms of time, material and labor, and flatter hierarchies were also formed accordingly. This philosophy has now extended to many areas of society, so the state and administration should also become leaner.

Improvement of the production result

Labor productivity
Another prerequisite for improving the performance result is an increase in the quantity of goods produced in relation to the quantity of production factors used. For example, an increase in productivity can mean that the same number of workers produces more goods in the same working hours. It can also arise from the fact that less working time was required for the same quantity of goods. This increase in productivity can be due to learning effects as well as improved work organization and the replacement of human labor with machines (automation). Productivity is usually measured in relation to the individual production factors and only becomes meaningful by comparing different periods.

This key figure is also used as an argument in conflicts over wage increases: If the production factors involved produce more goods in the same working hours, they all claim their share in the success of the work. However, since weighing decisions for the use of capital goods or for the use of labor also depend on their costs, productivity-related wage increases can in turn give rise to automation and thus to further increases in productivity.

The increase in productivity due to mechanization or automation in particular has always been the cause of fierce criticism, as jobs were considered to be threatened. Historically, this development has been associated with a considerable improvement in living conditions and standards of living. In the 19th century, for example, workers had to work up to 16 hours a day. Nevertheless, their wages were hardly enough for adequate nutrition, not to mention their health and life expectancy as well as their chances of participating in education and culture.

Profit: reward through the market

Profit
In order to survive in the long term, companies must act economically and strive for profit. Profit is the driving force behind entrepreneurial action: It is the "reward" for accepting risks. Profits are also the indispensable prerequisite for securing livelihoods, for expansion and maintenance investments and for the further development of goods and services. Profits only arise if the turnover achieved on the market is higher than the costs incurred in production. Profits are influenced by the demand, by the supply of the competition as well as by one's own use of the available resources. A company cannot choose the price arbitrarily, or maximize profit indefinitely, because consumers are unwilling to pay any price. The scope for winning is limited not only by customers, but also by existing and even non-existent competitors. If prices can be enforced on the market that are well above the production costs, high profits are possible in the short term: However, these also represent incentives for other providers to operate in this market. In the ideal case, the competition between the providers for the limited resources of the customers forces them to produce good quality products and at reasonable prices. Economic success shows in profit, failure in the form of losses.

So a high profit is not necessarily the reward for good economic performance. It could also be the result of a lack of competition or from consumers who do not pay attention to price and quality. It could ultimately result from the disinterest of citizens or their political representatives, who allow companies to outsource business costs at the expense of third parties or that fraud and deception are not adequately punished. Profit can also be generated by freeing up capital. Even though profit is the essential prerequisite for innovations and job-creating expansion investments, it is not only used for this, but there are also many other possibilities:
  • Profits can be used to buy back shares. In this way, the company value can be increased in the short term, while shareholders can look forward to growing dividends. Owners of capital interested in short-term increases in income and value tend to remain loyal to the company in the event of corresponding increases; they may also be more inclined to agree to an increase in manager income within the framework of the supervisory bodies.
  • With profits, mergers and acquisitions can be realized in order to eliminate unpleasant competition or overcapacities, they can also be used for foreign investments. They therefore often lead to the loss of jobs, but in some cases also to their security.
  • Profits can also be used to increase wages. Although this initially offers the possibility of increasing overall demand with purchasing power, it initially increases its own costs and does not flow back to the company directly as demand.
  • Profits can also be used for job-creating expansion investments. There is always a risk, however, as it is unclear whether the additional amount created can also be sold on the market in the long term.


Profitability: Interest on the capital employed

Entrepreneurs do not know in advance whether the use of the funds is worthwhile at all. But even if a service has been rendered and also canceled, it can only be said that it was worthwhile if a "reasonable" profit was actually achieved. Imagine that a small entrepreneur first invests 100,000 euros in equity and at the end of the year realizes that after deducting all costs, he has made a profit of 5000 euros. If he had invested the same money for six percent, he would probably have been spared hassle, hassle and many sleepless nights and additional stress, and he would have achieved a higher return with less risk. So if you only want to invest a return on your own or someone else's capital, you will certainly want to achieve at least the interest that risk-free government bonds allow you, but also a "trembling premium" to compensate for the risk of loss.

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In order to be able to compare whether a higher return can be achieved with an alternative use of equity, the profitability is determined. This expresses how much interest has been paid on the capital employed. The profit is related to the use of funds in order to be able to compare whether higher returns would have been possible with an alternative use of equity. A favorable return on equity can even be achieved with a low profit share in sales, namely if a high turnover has been achieved - as is the case with the food discounters, for example.

Above all, the capital owners are oriented towards high profitability. The composition of this key figure makes it clear that profitability is increased even if profit and equity or the equity base of the company are reduced. It seems plausible that, for example, fund managers who want to realize or avoid price gains or losses in the short term are even more interested in the development of profitability than owner entrepreneurs or family businesses who have an emotional relationship with the respective company, its products and its long-term development. Studies by the management consultancy Ernst & Young and the University of St. Gallen diagnosed a greater interest in long-term survival with permanently high dividend yields in family and owner-occupied companies, as well as an interest in continuity at the management level and independence, with the result that entrepreneurial decisions are less dependent on short-term decisions Align successes.